The Financialization of Global Commodity Markets

Pascale Massot

Introduction

Extractive commodities are a key part of the global economy, and the fact that they are physically rooted in specific geographical areas despite the wide dispersion of consumers gives these commodities unique characteristics. Extractive commodities must be extracted from nature, rather than produced (Le Billon 2012), and their geographical concentrations cannot be ignored without huge amounts of unproductive energy being spent. Global extractive commodity markets (Commodity Markets) are also unique in that they have largely remained outside of global regulatory structures.

The “financialization” wave that has swept global markets in the past 30 years has only recently included extractive commodities: many of these commodities remain outside exchanges or are excluded from major commodity indices. Iron ore, tin, uranium, potash or rare earths, for instance, are not included in major commodity indices such as the Dow Jones-UBC Commodity Index, the Goldman Sachs Commodity Index, the Thomson Reuters/Jefferies Index or the Deutsche Bank Liquid Commodity Index. They are just beyond the financialization frontier.

Commodity Markets were relatively stable for the second half of the 20th century due to stable demand, the presence of producers’ agreements, or the presence of benchmark pricing. These extractive commodities, however, have resurfaced on the list of top global economic and financial issues in the past decade, following the commodity bubble between 2002 and 2008 (see Figure 1).

Figure 1

Extractive commodities can be seen as a sort of litmus test for global economic cooperation and the functioning of global markets. Because these commodities usually lack substitutes and are frequently considered by states to be national security issues, these markets often involve national policy makers. These Commodity Markets can offer a window into the most pressing global governance issues including those on the agenda for the upcoming Russian G20 Leaders Summit scheduled for St. Petersburg.

Commodity Markets have been at the forefront of yet another profound transformation in the global political economy in the past decade: the (re)emergence of China as, arguably, the single most important economic actor in many global commodity markets. China’s importance to global commodity markets is systemically significant. By 2005, China ranked first in its consumption of all main metals (it accounted for between 15% and 33% of global consumption of aluminum, zinc, copper, iron ore, tin, nickel and lead). In 2011, it became the largest energy consumer at 20.3% of global energy consumption. Between 1999 and 2005, China accounted for nearly two-thirds of the growth in global demand of refined metals consumption (China’s average consumption growth per annum between 1990 and 2005 ranges between 16% and 24% in all main metals), compared with less than 10% for India (Streifel 2006).

This Global Summitry Report (GSR) will outline some of the major challenges facing Commodity Markets today. They arise from the lack of global governance and continued financialization. These concerns include the traditional drawbacks of financialization – increased volatility and increased systemic risk – combined with a de-institutionalization of market structures, increased asymmetry and a pervasive lack of trust by many countries. All these challenges are exacerbated by China’s emergence. As a result, these challenges to Commodity Markets just cannot be resolved by a “hands-off” approach to financialization.

Financialization

At the turn of the twentieth century, a variety of changes set the stage for the price bubble. Financialization in its broadest sense refers to the gradual transition of modern economies’ growth engine from an industrial base to a financial base (often grouped with the insurance and real estate sectors). The financial services, real estate and insurance portion of GDP went from less than 35% to over 90% of good-producing industries between the early 1980s and the 2010s (Foster and McChesney 2012). This broad trend occurs simultaneously with larger economic globalization.

In practice, the financialization of commodity markets have seen an increase in financial activities as a share of total income generated along commodities’ supply chains (Frenk 2012). This process has been defined as “the strengthening interaction of commodities markets with the financial system,” meaning that “returns from commodities are increasingly pooled with returns from pure financial assets” (Valiante 2013).

The financialization process has been a varied one. We have seen the gradual disbanding of most commodities producers’ agreements and long term pricing regimes as well as an increase in the velocity of trade of these commodities. A case in point is the global iron ore market, which is one of the latest Commodity Markets to undergo significant financialization. This transition from a long-term benchmark pricing system to a variety of overlapping short-term contracts has been accompanied by increased volatility and price levels (see Figure 2).

Figure 2

In addition, we have seen the creation of spot markets, and the incorporation of particular commodity prices in compound commodity indices as well as the increased depth and liquidity of related derivatives markets. We have witnessed the increased influence of financial investors (neither producers, nor consumers) in the trade of particular commodities. These changes have been enabled by deregulation.

Then there was the enactment in the United States of the CFMA (Commodity Futures Modernization Act) in 2000 (Frenk 2012). This legislation included regulatory exemptions and eliminated exchange trading requirements and position limits for financial institutions. Compounded by the availability of inexpensive credit, these changes set the stage for Commodity Markets speculation and volatility.

One of the main rationales for the financialization of commodities is that it allows the ‘price discovery mechanism’ to operate, and increases efficiency and transparency. The reality, however, is more complex. Unregulated financialization has actually led to direct drawbacks for end users of commodities, even beyond increased volatility and systemic risk.

In light of the level of complexity of financial instruments, it is not at all clear that transparency is automatically increased by financialization, or that it has the intended effects on market participants. Volatility and complexity can actually lead to increased cost of hedging against risk and tougher decision-making regarding storage for commercial end users. Finally, transparency is also notoriously hard to enforce and the unreliability of inventory data has led to herding behavior (Clapp and Martin 2011). Some have argued that as a consequence of financialization, price movements are less closely linked to fundamentals (UNCTAD 2011). Efforts should be made to better define the conditions under which effective transparency can occur.

Fairness and trust

China, as a newcomer, is particularly sensitive to perceptions of unfairness in global markets. Adding to that perception is the fact that global commodity markets operate under high levels of concentration (Nolan 2012).

China is understandably skeptical of multinational corporations’ commitment not to reduce production to inflate prices. Events in the global iron ore market over the past year have made that clear. A case in point: In March 2013, China’s National and Development Reform Commission (NDRC) released a report saying that the most recent surge in iron ore prices was partly the result of ‘unreasonable pricing methods’ by the biggest iron ore producers. The NDRC accused the big iron ore mining companies of ‘artificially inflating the price of iron ore, by delaying and controlling shipments, delaying sales, and causing a temporary illusion of shortage in the market.’ The economic agency went as far as to say that in consequence, the Platts iron ore index couldn’t be fully trusted, as these inflated prices were the basis for its calculation (Zhong 2013). BHP and Platts immediately issued a rebuttal (Riseborough 2013).

Supranational regulatory gaps have also allowed given established multinational corporations more leeway to influence the outcome of the game; for a recent example, see the current scandal over Goldman Sachs’ aluminum market shuffle, hoarding, and double-play (Kaminska 2013).

The relationship between transparency and commodity prices volatility is complicated. Trust deficits have to be addressed in order for increased transparency to be at all possible. More importantly, increased transparency, strictly speaking, will not be enough to provide a sense of security and fairness to developing countries dependent on imports, such as China. Deeper global market restructuring may be necessary, of the sort needed in many other international organizations, which is to facilitate the emergence of a role commensurate with China’s size. Institutional design and careful management of incentives and undue concentration can mitigate perceptions of unfairness.

Lack of trust is detrimental to policy coordination (Henry 2013). The above-mentioned accusations of cheating by the NDRC destabilized the relationship between China and global market stakeholders, at a time when markets were undergoing a massive transition.

Asymmetries

Three types of asymmetry clog the wheels of a healthy transformation of global commodity markets. First, national versus supranational governance asymmetry is not new, but is no less important in the case of commodity markets. Not only do Commodity Markets operate beyond the strict purview of the state, but it is also an area where orthodox WTO negotiations have stalled (specifically around issues of agricultural commodities). This gap results in a situation where multinational corporations operate largely unhindered and emerging economies – often the largest purchasers – have little to no pricing power.

Second, the emergence of several medium-to-large developing economies has brought to the fore questions of asymmetry in representation in global institutions. Indeed, developing countries are becoming more prominent economic actors, whereas most existing global commodity institutions, such as the International Energy Agency, do not include countries such as China. Current governance gaps are apparent, and the intensification of regionalization trends, hailed as a solution by some, is not enough for the establishment of stable and fair global commodity markets, not the least because commodity markets cannot mirror political regions perfectly.

Third, commodity markets are faced with a peculiar type of asymmetry: that of capacity versus will. China’s critical weight in global commodity markets is achieved at a time when it is also facing serious domestic rebalancing challenges, coupled with traditional challenges faced by developing countries – most prominently the middle income trap. Thus China’s size and rule-making potential is preceding its will for global leadership in many areas (Ruggie 1982). China has shown the tendency to support global consensus on certain issues, but not in others (Tiberghien 2012).

Chinese weakness

The above asymmetries reinforce the Chinese perception that global markets are flawed and unfair. Whether China will choose to toe the line or change the rules of the game is a question that remains entwined with domestic dynamics. China’s domestic challenges overshadow its capacity and willingness to play a larger role in international affairs, although some efforts are worth noting (Xu 2012). China’s domestic fragility is detrimental to commodity price stabilization as well as to the regulation of international commodity storage or demand management among the world’s largest market stakeholders.

The global community needs to encourage China to break up the cycle of inaction and foster a growing sense of responsibility and ownership in global institution building. It would help for China to more fully lay its ‘cards on the table’. The current Chinese position has emphasized specific outcomes, such as increased competition, lower prices, and stability, instead of stating clear institutional preferences for the governance of global commodity markets.

Issues to follow-up on at the G20 meeting in Russia

It is interesting to note that at a time when we are trying to come to terms with the aftermath of the global financial crisis, a crisis facilitated by too much unregulated financialization and too little global coordination, Commodity Markets remain set on a financialization course (Ivry 2013) (Kaminska 2013) (Kocieniewski 2013). To the extent that commodity prices have gone down from their 2007 highs, it has also lessened the sense of urgency that preceded the crisis and immediately followed it.

Though most commodity trading still occurs in the US, enough trading happens internationally that national US regulation will not be sufficient. The growth of new trading centers (for example, with the creation of an iron ore trading platform in Beijing in 2012) makes global coordination among international stakeholders all the more pressing. A compromise has to be found between overly lax and overly restrictive regulations, but at this point, the latter looks unlikely (UNCTAD 2011).

The French Presidency at the 2011 G20 was the boldest in tackling the commodity markets agenda, and strongly supported structural reforms to limit volatility, but the efforts failed to garner consensus in the end (Murphy 2013). Since then, the Mexican and Russian Presidencies have deemphasized the issue. Still, broader G20 objectives will have an impact on Commodity Markets, and the G20 Leaders have yet to finalize and approve actions for over the counter (OTC) derivatives, including the proposal to have trades “on exchanges or electronic platforms, cleared by central counterparties (CCPs) and reported to trade repositories” (Carr 2012).

The G20 can provide the background for trust building as well. The inclusion of an energy portfolio (and stated commitment to making energy and commodity markets transparent and more predictable) during the Russian Presidency could be productive in building trust at the leaders level and in turn through the international and national levels.

Financialization is a process fraught with pitfalls and intrinsically unstable, and if under-institutionalized, it will be difficult to solve issues of asymmetries and lack of trust – without which meaningful participation by Chinese and other developing countries’ stakeholders is unlikely.